Public Finance Perspective - Latvia

Public Finance Perspective - Latvia

Dmitri Maslitchenko dmitri@mailroom.com

      The Latvian people have lived in the Baltic-shore territory for more than 4,000 years, with the Latvian language being one of the oldest living languages of Europe.  "Latvia's location at an East-West crossroads, and her ice-free ports on the Baltic Sea, have made her an inviting target for expansional powers.".(EIU, 1995).  Over the centuries, Latvia has been occupied by the Teotonic knights of Germany, the knights of Sweden and Poland, and the tsars of Russia.  World War I and the fall of the Russian tsars provided an opportunity for numerous Russian colonies to break away.  Only Latvia, Lithuania, and Estonia gained and maintained independence on November 18, 1918, by signing a treaty with the new Soviet Russian government.  Latvia quickly began to develop a successful economy and joined the League of Nations in 1922. 

      In 1940, Stalin presented Latvia with an ultimatum, admit Soviet troops or face annihilation.  During the next fifty years, the Soviet Union ruled over Latvia.  Freedom of speech and press were abolished.  Access to western printed materials, radio broadcasts, and other communications were strictly forbidden, and religious activities were destroyed.  In 1987 large human rights demonstrations began to take place, with the most notable being the 1989 joining of hands in the unforgettable Baltic Way from Tallinn through Riga to Vilnius.  

        On May 4, 1990, the Supreme Council of the Republic adopted the Declaration on the Renewal of the Independence of the Republic of Latvia.  In a referendum held in March of 1991, the people of Latvia voted overwhelmingly in favor of democratic and independent statehood for the Republic of Latvia.  "Latvia's declaration of the restoration of independence in August of 1991 resolved many of the issues prominent during the transitionary period between occupation by Russian troops and Latvian independence." (World Bank, 1995).  The declaration lays down that Latvia is "an independent democratic republic, the sovereign power of which belongs to the people of Latvia, and its statehood is determined by the 1922 Constitution"(EIU, 1995).  On September 17, 1991, the Republic of Latvia was granted full membership in the UN.  On June 5, 1993, the 5th legislature (Saeima) was elected in general and democratic elections.

An overview of the Latvian Economy

      Latvia is rapidly becoming a dynamic market economy, with Estonia being the only other former Soviet state close to Latvia in the transformation.  However, the transformation has not been without effort, the IMF reported only a 2% growth in GDP in 1994, following declines in GDP in 1992 and 1993.  The government's monetary policies and reform programs have kept inflation under 2% a month, encourtaged growth in the private sector estimated to account for over half the GDP, and encouraged growth in trade with the West. 

      "Price reform in Latvia came in several stages, bringing relative prices more in line with world prices and reducing the excess demand for goods in Latvia.".(EIU, 1995).  By 1992 less than 8% of goods and services in the consumer price index remained under price controls.  The price reform "increased GDP, contributed to an improvement in the financial position of Latvian enterprises, and assisted in the improvement of the government budget"(EIU, 1995).  However, the effects on the economy were only temporary. 

      But even the price reforms could not pull Latvia out of a economic situation that was becoming worse in 1992.  "Depleting stocks of raw materials and energy resources and the continued lack of foreign financial resources coupled with a reduction in agriculture due to a severe drought assisted in the reduction of GDP by 30%.".(EIU, 1995).  Unemployment increased to 2%, profit and income tax revenues declined, and enterprise tax arrears continued to rise.  The negative impact of these events resulted in an increasing fiscal deficit.     

Recent reform efforts...

        Since Latvia regained independence in 1991, the government of Latvia has made substantial progress in stabilizing the economy and structural reforms.  "The government has been involved in a large effort to transform the economy from a centrally planned system to a market based system.".(EIU, 1995).  A comprehensive economic program was initiated late in 1992 which focused on stabilization.  Tight monetary and fiscal policies maintained an almost balanced budget through 1993 and reduced the rate of inflation, which declined steadily from over 900% in 1992 to less than 2% in 1995 (World Bank, 1995).   Prices and trading were liberalized.  "Efforts to restructure the banking system, to privatize the economy, and to demonopolize large state owned enterprises, encouraged the development of the private sector and allowed restructuring of domestic production, removed from highly subsidized and protected markets." (World Bank, 1995). 

      An important element of the reform efforts was the introduction of a national currency in 1992 which allowed the Bank of Latvia to pursue an independent monetary policy.  "Tight monetary policy was supported by a broadly balanced government budget in conjunction with tax-based income policy." (World Bank, 1995).  Since 1993 the country has had a stable currency, the LAT.  "The nominal exchange rate, since introduction, has continued to remain fairly stable against the dollar.". (EIU, 1995).   

      The government has also made reform progress in several other areas which include fiscal policy and the social safety net.  "Fiscal reform measures replaced the Soviet tax system with a modern tax system and shifted expenditures significantly from subsidies and transfers to enterprises, to other areas.".(EIU, 1995).  The government is still working in other areas including extrabudgetary funds and tax collection capacity.  A number of reform measures have also been taken to improve the social safety net, including the introduction of unemployment benefits and allowances to poor families.  However financial resources for social safety net reform measures continue to decrease as unemployment and pensions costs continue to increase.  "Financing of the social safety net has been re-examined to address its dependence on the wage base which has inflated the cost of labor and discouraged employment.".(EIU, 1995).

      Progress has also been made in structural reforms.  Prices have been liberalized, the trading has opened, banking institutions have been privatized, as have been a number of small businesses and agricultural land.  Latvia also seems to have weathered the banking crisis and the economy has begun to recover late in 1995 and has since experienced some growth in 1996.  The banking system has moved towards fairly stable and functioning private banks.  Progress has also been made in land restitution and agricultural privatization.  Much of the agriculture has already been privatized and the government plans to increase the pace of privatization of state enterprises.  Approximately two-thirds of the enterprises owned by government have been privatized.  Privatization of large enterprises has been at a slower rate, with only 85 of the 200 proposed projects completed by late 1994.(World Bank).  With the approval of laws establishing the Privatization Agency and the State Property Fund, the large enterprise privatization  increased its pace in accomplishing the goal of 75% privatization by 1996. (World Bank, 1995). 

        Latvia is thus in the midst of recovery, assisted by the country's strategic location on the Baltic and its well-educated population.

The Budget System

      Under former Soviet rule, public administration and management were highly centralized.  Since Latvia's independence in 1991, there has been substantial progress in decentralization of the local governments.  Until recently, there were three levels of local government:  rural districts and small towns known as pagasts, regions which included rural districts and small towns on their borders known as rayons, and seven major cities, including Riga, which administered both the pagasts and the rayons.  Legislation within the past year has simplified the administrative system to two levels ( 26 regions and 600 municipalities) and has clarified and separated responsibilities for expenditure.  "New laws provide for a stable and transparent system of revenue assignment, formalizing intergovernmental fiscal relations through allocations of tax revenues between the state and the local governments, and revenue equalization among the municipalities.". (World Bank, 1995).

Extrabudgetary Funds...

      Extrabudgetary funds' budgets and operations must be approved by Parliament.  The Social Security Fund is the largest of the extrabudgetary funds, accounting for over 28% of general government revenue.(World Bank, 1995).  This fund is administered by the Ministry of Finance and financed through the social security tax.  Expenditures of the fund include pension payments, sick pay, maternity pay, and family allowance.  The unemployment benefits are financed through 1.5% of the social security rate (World Bank, 1995).   

      Two other significant funds are the State Privatization Fund and the Environmental Protection Fund, which are financed through sales of government property and a natural resource tax respectively.  "The State Privatization Fund was established to manage revenues gained from the privatization of state-owned enterprises and the sale of other assets.".(EIU, 1995).  Municipalities located within the jurisdiction of the privatization of state-owned property also receive 5% of the revenues.  Riga is the only exception to this rule, and receives 10% of the revenue.  The Environmental Protection Fund gains revenue through the collection of fines on polluting enterprises and also through a percentage of the natural resource tax.  The fund then utilizes the revenue to finance projects which are expected to reduce pollution and protect the environment. 

Background of Budgetary Revenues...

      During the Soviet era, Latvia was a mainecontributor to the USSR budget, making financial transfers equivalent 20.2% of GDP.(World Bank, 1995).  In 1991 those transfers stopped and resulted in a Latvian surplus of 6.4% in GDP for the year(EIU, 1995).  However, social outlays continued to increase deficit in 1992 and 1993.  The 1993 budget ended the year with a deficit of approximately 2.9% of GDP (EIU, 1995).  A new system of taxation was introduced in January 1991, which included a separate profit tax for companies and enterprises.  In 1993, the profit tax was levied at a rate of 45% for banking insurance and trade, 35% for state enterprises and state companies, and 25% for all other private companies.  Personal income tax came into effect on January 1, 1994, levied at a rate of 25% on the first Lats4.800 and 35% on the remainder of the profit(EIU, 1995).  The value-added tax (VAT) was first introduced at a standard rate of 10% in 1992, and was raised from 12% to 18% in November of 1993 on most products excluding food (however the VAT was raised to 18% on food products in March of 1994).  The government has also begun to finance the deficit through the issuance of Treasury bills. 

Composition of Budgetary Revenues...

      Fiscal reform measures which have been implemented since 1990 have changed the structure of budget revenues, becoming similar to the structrue of revenues in Western Europe.  Income tax revenues have continued to increase while taxes on enterprises and domestic goods and services have decreased.  Social security contributions to total revenue have risen to levels similar to those in Western Europe.  New taxes which have been implemented are described below according to World Bank information as of the end of 1995. 

      Profit tax.  This tax is levied on the net earnings of enterprises, cooperatives, and private entities.  Self-employed persons may pay either the profit tax of the individual income tax.  The tax rate of the profit tax fluctuates between 25% and 45% depending on the institution.  Lottery, casino, and gambling profits pay a profit tax of 65%.  There are exemptions for associations which are run for charities, health, and the handicapped.  Legal deductions include expenditures by enterprises for social purposes.  "Adjustments in the value of fixed assets to an inflation index are currently infrequent and do not follow clear rules.".(EIU, 1995). 

      Personal income tax.  This tax is levied on individual's wage income, including bonuses, and the income of legal entities formed by individuals.  The basic rate is 25% with a marginal tax rate of 35% applying to income which exceeds 20 times the nontaxable minimum. 

      Social security tax.   This tax is levied on salaries, wages, fees, royalties, and other rewords for work.  The tax is payable in the following proportions by employees and employers.  Employers contribute 37%  and employees 1%.  For handicapped employees, the employer pays 8%.

      Value-added tax.  This tax is levied on goods and services at the manufacturing/import, wholesale, and retail stages.  The standard rate is 18%, with a reduced rate of 10% being applied to meat, fish, milk, and feed products.  This reduced VAT rate was switched over to the standard rate in 1994.  There are still exemptions, including medical supplies, concerts and theaters, and transit services. 

      Excise taxes and customs duties.  Excise taxes are levied on the imports of products by individuals or enterprises.  Customs duties are levied on imports and exports, with export duties ranging from 5% to 100% and import duties ranging from 2% to 20%. 

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